Lecture 2 - Recognition

Question 1

Recognition criteria

Answer 1

1. It is probable that any future economic benefit will flow to or from the entity; and
2. The item has a cost or value that can be measured reliably.

Question 2

Why is there a skewness of asset payoffs?

Answer 2

• Asset returns have systematic skewness  small number of extreme low probable events  but high payoffs.

Question 3

Intangibles recognition criteria:

Answer 3

Asset: a resource
- Controlled by an entity as a result of past events; and
- From which future economic benefits are expected to flow to the entity
Intangible asset: An identifiable, non-monetary asset without physical substance.
Identifiable:
- Separable – i.e. can be separated or divided from the entity and sold, transferred, licensed, rented or exchanged, either individually or together with a related contract, asset or liability.
Or
- Arises from contractual or other legal rights
AASB 138 – Internally generated intangibles cannot be identified.
- Subsequent expenditure on customer lists is expensed

Question 4

Contingent Asset/liabilities definition

Answer 4

• Possible assets or obligations  its existence is confirmed by events in the future.
• It is not recognised because it is not probable and cannot be measured with sufficient reliability.

Question 5

Consequences of non-recognition of contingent liabilities:

Answer 5

Net assets overstated
ROE=(↑Net Income)/(↑Equity )  Impact on ROE is ambiguous in the period in which the liability arises.
ROE will be understated in following years as NI will remain unchanged, and equity will remain overstated.

Question 6

5 Consequences of non-recognition of intangibles

Answer 6

1. Measurement error in financial reports
2. Non-comparability between companies with different assets
3. Lack of accountability for investment in intangible assets
4. Influence managerial incentives (to manage earnings and non-investment in R&D)
5. Macroeconomy - increases adverse selection –> misallocation of resources

Question 7

Why is the bias of ROE/NI dependent on the rate of growth in investment.

Answer 7

Constant Investment:
- NI Correct

Increasing Investment
- NI Understated

Decreasing Investment
- NI Overstated

Question 8

Why non-recognition of intangibles?

Answer 8

1. guard against managerial optimism

2. increased reliability.

Question 9

How should intangibles be reported?

Answer 9

Report standard errors (i.e. reliability of the information)

Question 10

Measurement issues associated with reporting intangibles.

Answer 10

• Lack of full control over the benefits (partial excludability)
• Absence of active markets
• Internally generated (not necessarily separable)
• High risk (low probability, high payoff)

Question 11

Are internally generated customer lists recognised?

Including additional expenditure (enhancement)

Answer 11

No.

Question 12

Why are internally generated intangibles not recognised?

Answer 12

• The cost of developing these assets cannot be distinguished from the cost of developing the business (i.e. cannot be separated)
• Incomplete property rights
• No exit strategy (high risk owning intangibles)